The NUA in an LSD of employer securities is excluded from the recipient’s gross income under Sec. 402(e)(4)(B). The NUA can be excluded from income even if the employee receiving the distribution has not been a plan participant for five years. The amount included in income by the recipient (i.e., FMV less NUA) is taxed under the LSD rules (Sec. 402(e)(4)(D)). The employee’s share of the plan’s basis in the employer securities distributed is the amount included in gross income. If the distribution is not part of an LSD, the NUA excluded from the recipient’s gross income includes only the amount attributable to nondeductible employee contributions. The NUA attributable to deductible voluntary employee contributions is taxable; see Sec. 402(e)(4)(A) and Szilagyi , TC Memo 1982-656.
When employer securities are sold after distribution, any gain realized is long-term capital gain subject to a maximum 15% rate, to the extent attributable to NUA not taxed at the time of receipt of the securities. The long-term or short-term status of any capital gain in excess of this amount depends on how long the distributee actually holds the securities after distribution from the plan; see Notice 98-24 and Regs. Sec. 1.402(a)-1(b)(1)(i)(b). For this purpose, the employee’s holding period in the securities begins on the day after the date they are delivered to the transfer agent with instructions to reissue the stock in the employee’s name; see Rev. Rul. 82-75 and Letter Ruling 8724049.
Rolling over Appreciated Employer Stock
Distributions of employer securities can be rolled over to an eligible retirement plan whether or not they are distributed in an LSD. However, retaining direct ownership of appreciated employer stock received in an LSD (instead of rolling over to an eligible retirement plan) provides the following tax advantages:
- The employee is taxed only on the shares’ cost basis, not the FMV.
- The 10% early distribution penalty, generally applicable if the employee has not attained age 59½ at the distribution date, is based on the shares’ cost basis (to the extent this basis is currently taxable), rather than their FMV.
- Any gain on disposition of the stock is normally taxed as long-term capital gain instead of ordinary income.
- Because the stock is not in a traditional IRA or qualified plan, it is not subject to the minimum distribution rules. Accordingly, taxes on the NUA can be deferred indefinitely until the shares are sold.
- If the stock is still owned at death, the employee’s heirs will receive a stepped-up basis for any appreciation in the stock during the time the employee holds it. There is no increase in basis for the NUA in the stock before the securities were distributed; see Sec. 1014(a) and (c). The NUA is considered income in respect of a decedent.
Example 1: Sally leaves her job and receives an LSD from her employer’s Sec. 401(k) plan when she is age 50. The distribution consists of $200,000 cash and $100,000 worth of employer stock. The cost basis of the distributed stock is $10,000; thus, $90,000 of the NUA is attributable to the stock ($100,000 – $10,000). If Sally rolls over the $200,000 into an IRA and keeps the stock, she will pay income tax and the 10% early distribution penalty on only the $10,000 of stock basis. She then can continue to defer tax on the $90,000 NUA on the stock. When Sally sells the stock, the first $90,000 of gain will be taxed as a long-term capital gain. Any additional appreciation in the stock at the time of sale will also receive capital gain treatment. The long-term or short-term nature of this additional appreciation will depend on whether Sally has held the stock for more than a year before selling it.
Example 2: Instead of keeping the stock, Sally rolls over the entire $300,000 LSD into an IRA. She will pay no income tax or early distribution penalty, but will not be able to use the preferential long-term capital gain tax rate on any subsequent distributions from the IRA (because the $90,000 NUA loses its long-term capital gain status and is taxed at ordinary income tax rates when distributed from the IRA). Thus, by not rolling over the appreciated stock into an IRA, Sally pays a relatively small amount of income tax and penalty now, in exchange for receiving favorable long-term capital gain treatment in the future.
Caution: This favorable tax treatment for employer securities applies only to an LSD. If the distribution is not part of an LSD, the full FMV of the securities (in excess of any nondeductible contributions made to the plan) is generally included in the employee’s income. However, even in this situation, NUA attributable to nondeductible (i.e., after-tax) employee contributions can still be excluded, under Sec. 402(e)(4)(A).
Each of the advantages previously listed represents some not-so-common provisions of the tax law that can save clients substantial tax dollars. However, these strategies are not for everyone. They work best when the employer stock is highly appreciated and 10-year averaging is not available or does not make sense. As is the case with most tax planning alternatives, the numbers on all available options should be analyzed before making a decision.
Electing to Be Taxed on the Full FMV
Employees who receive a distribution of employer securities may elect to include the full FMV of the LSD, including the NUA of the securities, in income. Although making this election generally accelerates the recognition of income, it may be beneficial for individuals using the favorable LSD 10-year averaging method.